Brazilian central bank board member
Carlos Hamilton so disagreed with a surprise interest-rate cut
in August that he slammed phones and stomped through hallways,
according to three bank officials familiar with his reaction.

Hamilton and a second dissenter have since joined unanimous
decisions to lower rates twice more as Europe’s debt crisis
dents confidence in Brazil and the annual pace of price
increases slows. Still, with economists predicting that a report
tomorrow will show inflation (BZPIIPCY) last year reached 6.55 percent,
exceeding the target range for the first time in eight years,
his initial caution is timely.

The rate-cutting strategy is putting at risk the bank’s
reputation as a guardian of price stability, said John Welch,
chief emerging markets strategist for CIBC World Markets, the
investment-banking arm of Canada’s fifth-largest bank.

Fighting inflation is a challenge in Brazil as President
Dilma Rousseff presses to fulfill her pledge of slashing a 4.36
percent real interest rate that is the highest in the Group of
20 nations.

“They have to change their minds or completely give up
inflation targeting,” Welch said by telephone from New York.
“This was a risky bet they probably shouldn’t have made.”

Less Predictable

Brazil began targeting price increases in 1999 to tame a
legacy of hyperinflation that peaked at 6,821 percent in 1990.
Since then, interest-rate policy in Latin America’s biggest
economy followed a familiar pattern where the benchmark rate (BZSTSETA)
rose and fell in tandem with inflation expectations, according
to AllianceBernstein LP, a New York-based investment firm.

In August, that pattern became less predictable when the
bank cut rates even before inflation began to ease,
AllianceBernstein said in a September report.

Policy makers led by bank chief Alexandre Tombini surprised
all 62 analysts surveyed by Bloomberg who forecast borrowing
costs would be left on hold and instead cut the Selic rate a
half-point to 12 percent. Coming after five straight increases,
it was the most abrupt turnaround in monetary policy since 1999.

The bank at the time of the decision and in communications
since said it needs to act in a “timely” way to offset a
global economic slump. “Moderate adjustments” to its rate
won’t compromise policy makers’ goal of bringing inflation to
the 4.5 percent target in 2012, the bank said.

Praise for Cuts

The pre-emptive action has its supporters.

“They did well in anticipating the crisis,” said Andre Perfeito, chief economist with Sao Paulo-based Gradual
Investimentos. “Trying to control inflationary pressures,
mostly from services, would have had a huge social and economic
cost -- it would have meant a recession.”

The breakeven rate, which reflects investors’ expectations
of average annual inflation until 2013, was 5.8 percentage
points yesterday, down from a three-year high of 6.5 percentage
points Sept. 21. The gauge, derived from the yield difference
between inflation-linked bonds and interest-rate futures
contracts, averaged 5.39 percentage points since year-end 2008.

Other emerging market central banks, such as Thailand and
Indonesia, also have cut borrowing costs as the global economic
outlook worsened.

Growth Slowing

The 48-year-old Tombini’s pessimistic outlook is proving
true in part, as investors’ appetite for riskier, emerging
market assets wanes and slowing global demand cuts prices for
iron ore, Brazil’s biggest export. Gross domestic product in the
third quarter shrank for the first time since 2009, cementing
expectations that growth (BZGDYOY%) last year slowed to 2.87 percent from
7.5 percent in 2010, according to a Dec. 30 bank survey.

The bank said “benign” commodity prices, stable fuel
costs and falling domestic capacity use will help contain price
pressures. Brazil’s broadest inflation index (IBREGPMY), which is 60
percent weighted in wholesale prices and is used to adjust
everything from rents to utility rates, fell in December for the
first time in five months.

Still, policy makers aren’t out of the woods.

While inflation has eased from 7.31 percent in September,
economists expect tomorrow’s report to show the pace of price
increases accelerated in December for a second month, pushing
the year-end inflation rate to 6.55 percent last year--the
highest since 2004. Inflation this year may reach 5.32 percent
and is unlikely to return to the 4.5 percent target until 2015,
the central bank survey shows.

“That August move should never have happened,” said
Alexandre Schwartsman, a former central bank director from 2003
to 2006 and now a consultant in Sao Paulo. “They’ll realize
they won’t make the target.”

“All this means the central bank has to do more than it
usually does to bring inflation down,” said Welch, who played
soccer with Tombini while both were earning their doctorates in
economics at the University of Illinois at Urbana-Champaign.

The August cut also fueled speculation of political
meddling. A day before the surprise decision Rousseff vowed to
take Brazil on a “new pathway” of lower borrowing costs
“starting now.” The same week the government boosted its
primary budget surplus target by 10 billion reais ($5.5 billion)
to help pave the way for rate cuts, Finance Minister Guido Mantega said at the time.

“The poor communication, the surprise, and the
announcement of the primary surplus led the market, including
us, to suspect political interference,” Alessandra Ribeiro, a
monetary policy analyst with Tendencias Consultoria Integrada,
said by telephone from Sao Paulo.

Venting Frustration

Following the 5-2 vote presided over by Tombini, Hamilton
vented his frustration to a colleague, saying that he was a
technocrat not a politician, according to all three officials,
who requested anonymity because of the sensitivity of the
matter.

The second dissenter in the conference room on the 20th
floor of the central bank’s modernist headquarters in Brasilia
was likely Altamir Lopes, administrative director, the bank
officials and economists familiar with his views said.

“I’ve known Altamir for years,” Carlos Thadeu de Freitas,
a bank director in 1985-86, said by telephone from Rio de
Janeiro. “He’s a rigorous monetarist and wouldn’t have
supported such a risky move.”

The central bank in an e-mailed response refused to comment
on how board members voted in August, or on Hamilton’s reaction.
Hamilton and Lopes declined to comment when contacted through
the central bank’s press office.

Independence

Unlike the Federal Reserve, Brazil’s central bank doesn’t
reveal how each deputy governor votes. That’s in part to protect
from scrutiny board members who, in the absence of independence
for the bank, can be fired at any time. Proposals to grant board
members fixed terms have little support in Rousseff’s Workers’
Party and have been stuck in Congress for years.

Like Tombini, both Lopes and Hamilton worked their way up
through the ranks of the central bank. Lopes, 59, served as head
of the bank’s economics department from 1995 until 2011.
Hamilton, 47, joined the bank in 2000 and served as head of the
research department before taking his current post as economic
policy director in 2010.

The August dissent stemmed from disagreement over the
timing of a rate cut and not the need for one, according to the
minutes to the decision.

“Two members of the committee consider that the current
moment still doesn’t offer all the necessary conditions for this
move to take place immediately,” the minutes said.

Tension Easing

Since August, tension on the board has eased considerably,
and Tombini and Hamilton remain close friends, according to two
of the officials. The third-quarter contraction and three
straight months of declines in industrial output have bolstered
Tombini’s argument that inflation dynamics are under control.

The view among investors remains mixed. While traders
expect the bank to keep cutting rates by as much as 100 basis
points, they pared back their bets for the Selic to fall into
the single digits for the second time since 1999 after the
unemployment report was published Dec. 22. Yields on the
interest-rate futures contract due January 2013 rose to 10.13
percent from 9.63 in late November, according to data compiled
by Bloomberg.

With board members in agreement about tolerating higher
inflation for the time being, there’s unlikely to be any
opposition to further rate cuts, said Rogerio Mori, an economics
professor at the Getulio Vargas Foundation business school in
Sao Paulo.

“It’s a more dovish central bank than the last,” Mori
said in a phone interview. “Perhaps the most dovish in a decade
and a half.”